California's Failed Electric Power Industry Reforms

"By September 2000 utilities were paying nearly three times as much for power in the wholesale
market as they could charge at retail."

California's electric industry restructuring and competition program has encountered numerous
setbacks and difficulties but NBER Research Associate Paul Joskow uncovers
important lessons from
the recent debacle. The problems, he writes, were not inherent with deregulation but rather with the way
California implemented its reforms plus "a good deal of bad luck and ineffective government responses."

In California's Electricity Crisis (NBER Working Paper No. 8442),
Joskow begins by
discussing the structure of California's new retail and wholesale electricity markets. The state's
electricity market was long organized around three private electricity companies that were granted
monopolies to provide all the electricity for consumers in their franchise areas. In turn, the California
Public Utilities Commission (CPUC), an independent state agency, heavily regulated these companies and
the retail prices they were allowed to charge. While utilities in California owned and operated their own
generating plants to supply electricity, they also purchased significant amounts of power in the wholesale
market from utilities in other Western states, Canada, and Mexico. The Federal Energy Regulatory
Commission (FERC) was responsible for regulating prices charged by one utility to another for wholesale
power.

In the late 1990s an extremely complicated program of industry restructuring and reforms
designed to create competitive wholesale and retail markets for electricity was enacted, motivated
primarily by pressure from business customers wanting to reduce California's retail electricity prices,
which were among the highest in the United States. An important component of California's restructuring
program was to give retail customers a choice of using a competitive electricity service provider or
continuing to buy service from their local utility at a regulated default service rate. The hope was that
competing retailers would be able to offer consumers a price lower than the regulated default price.
Surprisingly, only about 3 percent of retail customers switched to the competitive pricing provider,
leaving the utilities largely responsible for providing service at a regulated default rate. But the default
service pricing formula effectively capped the retail prices of generation service for four years. At the
same time, the utilities were required to divest most of their generating capacity and to buy power in the
wholesale market at unregulated prices. Moreover, they were not permitted to hedge their default service
obligations by entering into forward contracts with wholesale power suppliers. As a result, a large
fraction of retail demand was being met through California's new wholesale spot market institutions.
While there were problems with the performance of the new industry structure from its start in 1998, they
did not lead to wholesale prices that were much higher than had been expected. Then in May 2000,
market design problems, regulatory failures, and some very bad luck led to dramatic and unexpected
changes in wholesale market performance.

In May 2000 wholesale electricity prices began to rise significantly, increasing 500 percent
between the second half of 1999 and the second half of 2000. The primary reasons for the initial run-up
in wholesale prices are: the price of natural gas, the primary fuel used to generated electricity in
California, rose to unprecedented levels; electricity demand soared because of unusually hot whether and
strong economic growth, while no new generating capacity had been completed in many years to serve
growing demand; the prices of air emissions permits required by generating plants also rose by a factor of
more than ten; finally, suppliers were able to exploit these supply and demand conditions by withholding
capacity from the market and driving prices up even further. While wholesale price rose, retail prices
continued to be capped by state regulation and the wholesale prices that utilities were paying to meet their
retail service obligations quickly rose to levels far in excess of these regulated retail prices. By
September 2000 utilities were paying nearly three times as much for power in the wholesale market as
they could charge at retail. By December 2000 they were paying over six times as much. Utility credit
problems quickly emerged as the utilities exhausted their cash and lines of credit. The utilities pleaded
with the CPCU to lift the retail rate freeze to restore their credit, but to no avail. In January 2001 the two
largest utilities effectively became insolvent and stopped paying their bills and unregulated generators
began refusing to supply for fear of never getting paid. To compound the supply-side problems,
consumers had no incentive to reduce consumption of electricity because retail prices did not adjust to
reflect wholesale market conditions.

To avoid widespread blackouts, in January 2001 the state stepped in and began buying power
from unregulated wholesalers, first in the spot market and later through longer-term contracts. Between
January and May 2001, at the direction of Governor Gray Davis, California spent roughly $8 billion on
purchased power to cover the utilities' "net short" position, mostly in the spot market. The state also
initiated a program to sign longer-term contracts with unregulated power suppliers, stretching out for as
long as 20 years, in the hope that this would constrain spot market prices and encourage investment in
new generating capacity, incurring state obligations of approximately $50 billion. The enormous cost of
these contracts will be paid through higher future electricity prices, state tax revenues, or a combination.
The state also initiated an expensive energy conservation program to cut demand. Finally, in June 2001
retail price increases averaging 30 to 40 percent went into effect.

Just as retail prices rose in June 2001, wholesale prices started to drop and continued to fall all
that summer and into the fall. By September they had fallen back to the levels prevailing before the crisis
began. The falling prices are attributed primarily to lower natural gas prices, lower demand resulting
from customer conservation, large amounts of generating capacity that had been out of service during the
previous few months returning to service as a consequence of a FERC mandated price mitigation
program, the contracts signed by the state, and changes in an important air emissions control program. By
Fall 2001, many concluded that the crisis was over. But Joskow advises caution before drawing that
conclusion. The state's largest utilities remained insolvent, the state is on the hook for tens of billions of
dollars of contract costs, the new wholesale and retail market institutions are in shambles, and the future
institutional arrangements that will govern California's electric power industry remained uncertain,
threatening future investment.

Joskow points to a multitude of lessons to be learned from California's unfortunate experience.
The state seriously underestimated the challenges associated with creating well functioning competitive
electricity markets. And both state and federal regulators failed to respond quickly or effectively to
market problems when they emerged. Competitive electricity markets cannot work properly if
consumers are completely insulated through regulation from variations in wholesale market prices. The
failure of retail prices to respond to changes in wholesale market conditions led to the credit problems and
insolvencies and destroyed incentives for customer conservation. To the extent that retail consumers are
"hedged" against fluctuations in wholesale market prices, those obligated to supply them must be allowed
to hedge their obligations through forward contracts in the wholesale markets. Not only do such contracts
provide a valuable risk management service to consumers, but they also reduce incentives suppliers have
to withhold capacity from the spot market to drive up spot market prices. Spot electricity markets also
perform poorly when supplies are very tight Accordingly, it is important to remove unnecessary
administrative barriers to speedy completion of new generating plants and transmission networks. Finally,
when market problems do emerge, government officials should act quickly and decisively to fix the
problems. If California and federal regulators had done so in September 2000 when the current problems
became crystal clear, they would have reduced significantly the ultimate magnitude of the crisis.

-- Marie Bussing-Burks

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